Analysis: What oil worry? Options market slumps despite Iran risk

NEW YORK If the oil options market is to be believed, the risk of an abrupt, dramatic move in crude prices has rarely been lower.

Even as traders warn that a shock attack on Iran, a release of emergency oil reserves or a slowdown in Chinese growth could roil the market at any time, options prices suggest that demand for protection from such risks has fallen away.

The Chicago Board Options Exchange's Oil Volatility Index .OVX -- a measure of fear or optimism in the market -- has dropped more than a third this year to its lowest since the outbreak of fighting in Libya in February 2011, and is close to the weakest level since the launch of the index in 2007.

Option traders explain the apparent disconnect between broad oil market sentiment and options pricing by pointing to a shift in the tone of Middle East tensions, saying the fear of an imminent U.S. or Israeli strike against Iran has receded for now. Oil prices have also stabilized over the past three weeks after rallying by $35 a barrel from October to March.

"We've been in an environment of fewer headline-driven moves," said Michael Hiley, head of energy over-the-counter (OTC) markets at Newedge in New York.

"We've already priced in the loss of a certain amount of Iranian crude."

Brent oil traded around $123 a barrel on Thursday, while U.S. crude was near $103.50 a barrel. Both were within $7 of highs hit at the start of the month.

Options are an imperfect gauge of sentiment as prices are far more readily influenced by short-term demand than the larger futures market. Other factors beyond the headlines have also contributed to the slump in volatility.

It may be a seasonal lull in the risk-management activities of big corporations, with producers such as Mexico and consumers such as airlines having wrapped up annual hedging programs in the latter part of last year. Oil companies have also been slow to lock in current prices in the hope they will keep rising.

Traders also pointed to a sell-off among big options speculators, who have cut their losses after a six-month slide. The collapse of MF Global, which had been a major clearing broker, has sidelined some traders; the number of open option positions has fallen by a quarter over the past year.

The OVX index uses options prices tied to the exchange-traded United States Oil Fund (USO) to gauge expectations of volatility over the next 30 days.

OPTION PRICES FALL

The move is in sharp contrast to the end of last year, when oil traders were torn between two opposing "fat tail" risks that threatened to have an outsize impact on prices: the possibility of a military confrontation with Iran or the collapse of the euro zone.

That saw traders piling into option markets for insurance, giving them the right to buy or sell oil at a predetermined price and date in case of a price spike or collapse.

"Traders are becoming more relaxed about the Iran scenario," said Jared Woodard, principal at Condor Options in New York, and author of "Options and the Volatility Risk Premium".

"Options on oil were priced extremely highly three to four months ago, but now they're trading at cheaper levels."

The price of a call option giving the right to buy crude at $150 a barrel in December 2012 rose to $1.54 a barrel in January, but has since slumped to just 85 cents.

Put options, which give the buyer the right to sell, for crude at $80 a barrel in December 2012 have fallen from $4.89 a barrel to $1.72 over the same period. "MF Global took a lot of participants out of the market and hurt a lot of people," said Frank J. Cholly, senior commodities broker at RJ O'Brien in Chicago. "You've got to believe that's part of the reason for the drop-off in volume and options open interest since then."

Since hitting 4.5 million in March last year, the number of outstanding options contracts on the New York Mercantile Exchange declined by about a quarter to 3.3 million at the end of last month.

RISKS PRICED IN

To be sure, the risk of large price moves in oil hasn't gone away.

While volatility has fallen across many financial markets this year, with the closely watched VIX equities index at the lowest level in five years, the decline in oil's "implied vols" has surprised many, including Goldman Sachs.

"(The decline) is remarkable given the tensions around Iran and the economic concerns over China," Goldman analysts said in a note to clients on Wednesday. They said ebbing volatility showed prices had risen on the back of improving demand.

Traders said they now thought Israel was less likely to strike Iran's nuclear facilities in the near term than many had thought prior to Israeli Prime Minister Benjamin Netanyahu's visit to Washington in early March, when he indicated he would give sanctions against Tehran time to work.

But many added it was only the timeline that had shifted, not the underlying concern.

"It's unfortunate but something bad is going to happen in the coming months, either with Israel and Iran or the European debt situation," said Matthew 'Whiz' Buckley, the founder and CEO of Top Gun Options in Boca Raton, Florida.

Others said the possibility of a U.S.-led release of strategic oil stocks may encourage traders to book profits, while high prices at the pump have also dented consumption. Additionally, the euro zone's debt problems have been only "kicked down the road", many traders said, rather than resolved.

But short of an outright global recession or euro zone collapse, most traders and analysts say Iran remains the primary "fat tail" risk with the potential to spark the biggest oil price move. Some predict an immediate spike to $150-200 a barrel in the event of a military confrontation. "If we compare the oil disruption from Libya last year, which cut around 1.3 million barrels per day (bpd), we saw oil prices jump from $84 in U.S. crude to nearly $107 over just a few weeks," said Carl Larry, analyst at New York-based Oil Outlooks, adding Iran produces more than 3.4 million bpd. "I don't think we've even begun to price in a real disruption from Iran."